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Budgetary and Tax Impact of the 'Buffett Rule'

With the "Buffett Rule" set to get a vote in the Senate next week, we felt it was a good time to take a more in-depth look at the proposed policy -- at both its budget and tax impact.

The Joint Committee on Taxation has estimated that the Buffett Rule would raise $47 billion over ten years, although this is against a current law baseline, which assumes that dividends will already be taxed at ordinary income rates and capital gains rates will rise to about 25 percent. The bill's sponsor, Sen. Sheldon Whitehouse (D-RI), has claimed that relative to a current policy baseline, with capital gains and dividends taxes at a top rate of 15 percent, the revenue raised would be $162 billion. Tax Policy Center made alternate estimates that showed it would raise $115 billion relative to current law and $265 billion relative to current policy. The large difference between these estimates, though, is mostly due to the fact that TPC scores the Buffett Rule after a repeal of the AMT, meaning that more taxpayers would be hit by the Buffett Rule.

So how exactly would the Buffett Rule work? The short answer is that it would require those making over $1 million to pay an average tax rate of at least 30 percent, even though some pay substantially less today due to various deductions and the preferential treatment of capital gains.

To avoid imposing an astronomical jump in tax liability when income goes from $999,999 to $1,000,000, the bill instead phases in the 30 percent alternative tax rate for incomes between $1 million and $2 million. It does this by making taxpayers in that income range pay a hybrid of their taxes under the current tax system and the new system. Economically speaking, the taxes paid would be the amount paid under the normal system on the first $2 million of income, plus an additional rate (or "bubble rate") on income between $1 and $2 million.

The formula for determining the marginal rate between $1 million and $2 million is 60 percent minus the original effective tax rate; thus, the highest "phase-in rate" that is theoretically possible is 60 percent for a millionaire who pays no income tax (having to make up $600,000 in taxes to get to the 30 percent rate over a $1 million range).

Below are a series of graphs that illustrates the marginal and effective tax rates of different hypothetical taxpayers. The first is a taxpayer with a 20 percent effective tax rate.

Tax Rate for Taxpayer with 20 Percent Rate

Here is a similar example with a taxpayer whose effective tax rate is at 25 percent at $1 million. In this case, earned income is actually taxed at the same rate as it was before, but the tax rate for capital gains still jumps.

Tax Rate for Taxpayer with 25 Percent Rate

Finally, here is the theoretical Buffett Rule rate schedule for the top 400 taxpayers based on 2008 data. They had an average effective tax rate of 18.1 percent, so the average top 400 taxpayer's marginal "bubble rate" would be 41.9 percent.

Tax Rate for Top 400 Taxpayer

These graphs come with the caveat that the Buffett Rule allows the charitable deduction to be counted against the tax, which is not represented in these graphs. Thus, the effective tax rate of these taxpayers could still vary based on the amount of charitable contributions that each individual makes.

In any case, comprehensive tax reform could offer a much more elegant and pro-growth solution to the problem the Buffett rule is trying to address. The "modified zero plan" from the Fiscal Commission, for example, asks for the top one percent of income earners to contribute eight percent more of their after-tax income to taxes, while asking only one percent from the middle quintile and providing a small tax cut to the lowest quintile. The Domenici-Rivlin tax plan is also progressive. Both of these plans eliminate or reduce most tax expenditures and tax capital gains and dividends at earned income rates.

But both approaches could help control rising debt by raising additional revenue, depending on how they were designed.

Correction: This blog originally stated that the difference between Tax Policy Center and JCT estimates was due to differing assumptions about taxpayer behavior, but we have been informed it is because of differences in interacting policy assumptions.